EM Back at 2002 Valuations, Still Not a Buy, Deutsche Bank Says

By Ben Levisohn

Emerging markets look cheap–as cheap as they did back in 2002, when a bull market began that carried them to a 450% gain from 2003 through 2007. But don’t make the mistake of thinking they’re cheap, Deutsche Bank’s John Paul Smith said in a report released yesterday.

Reuters

The MSCI Emerging Markets Index has a price-to-book ratio of 1.67 as of Feb. 21, Smith says, identical to the indexes P/B ratio in 2002. But there are big differences between now and then. He writes:

In 2002, following a series of economic and financial crises, there was a positive shift towards capital-friendly economic policies and corporate governance taking place across most of the EM universe, which had gone almost completely unrecognized by investors. By contrast today, the situation has reversed with no visible improvement in corporate governance in privately controlled companies and a pronounced tendency across the BRICS in particular, for increasing levels of state intervention to the detriment of minority investors, with the partial exception of India. The result is a polarization of valuations within GEM, which is a very bearish indicator, as, unlike 2002, practically all of the cheap sectors and stocks have fundamentals which are visibly deteriorating.

What will send emerging markets lower? How about another downturn in China’s rate of economic growth?

We believe that 2013 will mark the year when economists and investors focus on the underlying imbalances within the Chinese economy, and accordingly reduce their expectations of sustainable growth over the medium term. The deterioration in the perception of China is likely to have a very disruptive effect on GEM equities through both fundamental factors and fund flows, and there are few obvious hiding places within the asset class.

Emerging market pain, however, is the U.S.’s gain, Smith says. He expects U.S. stocks to gain 10% this year, while the MSCI Emerging Markets loses 10% to 15%.

While buying cheap, beaten up countries like Brazil and Russia and selling more expensive ones like Turkey and Mexico might seem compelling, he doesn’t recommend such a move at this time. Instead, he tells investors to own less China, Brazil, Russia and Korea relative to the benchmark, in favor of Turkey, Mexico, Poland and Taiwan. But even that doesn’t make Smith feel hunky-dory. “…the only recommendations within GEM, which we feel especially strongly about at this stage are to underweight Chinese equities and to overweight cash,” he says.

About Emerging Markets Daily

Emerging markets have been synonymous with growth, but the outlook for individual nations is constantly changing. Countries from Brazil and Russia to Turkey face challenges including infrastructure bottlenecks, credit issues and political shifts. The Barrons.com Emerging Markets Daily blog analyzes news, data and research out of emerging markets beyond Asia to help readers navigate the investment landscape.

Barron’s veteran Dimitra DeFotis has been blogging about emerging market investing since traveling to India and Turkey. Based in New York, she previously wrote for Barron’s about U.S. equity investing, including cover stories and roundtables on energy themes. Dimitra was among the first digital journalists at the Chicago Tribune and started her career as a police reporter at the Daily Herald in the Chicago suburbs. Dimitra holds degrees from the University of Illinois and Columbia University, where she was a Knight-Bagehot Fellow in the business and journalism schools.